ISEN302

ISEN 302--502
502 Spring 2020

ISEN 302: Economic Analysis of Engineering Projects

Chapter 8. Depreciation
ISEN 302 - 502
504 Fall 2018

Depreciation
Depreciation
• The reduction in value of an asset/property over time.
• Due to wear and tear, natural decay or decline,
obsolescence of property, etc.

2
ISEN 302 - 502
504 Fall 2018

Depreciation
• Depreciation is important because U.S. tax law permits
its deduction from taxable income.
taxes = (income – costs) tax rate
costs = expenses depreciation allowances

• Depreciation allowances are treated same as expenses

although they are not cash flows.

• Depreciation affects the amount of taxes to pay.

3
ISEN 302 - 502
504 Fall 2018

Depreciation: example
• Without depreciation
• A firm has $1,000,000 of taxable income.
• If its tax rate is 25%, the taxes to pay equals to $250,000
ignoring depreciation.

• With depreciation
• If the firm can deduct $50,000 in depreciation charges, its
net taxable income is $950,000.
• Thus, it would pay taxes of 0.25($950,000) = $237,500.

• Reduction in taxes
• Consideration of depreciation saves $250,000 – $237,500 =
0.25($50,000) = $12,500 for the taxes.

4
ISEN 302 - 502
504 Fall 2018

Depreciation for engineering decisions

• Design a production process that will be performed by
people vs one that will be performed by robots.

People
• Labor costs: treated as
expenses; fully deducted
from taxable income
Robots
• Robots’ operating costs:
treated as expenses.
• Acquisition costs for the
robots: depreciation.
5
ISEN 302 - 502
504 Fall 2018

Classes of business property

• Tangible property: property that can be seen or
touched. Depreciation
• Real property: land and generally anything that is erected
on, growing on, or attached to it.
e.g., land, buildings, factories, etc.
• Personal property: income-producing, tangible property of a
corporation except real property.
e.g., vehicles, computers, machinery, etc.

• Intangible property: property that cannot be seen or

touched, but has value to the owner. Amortization
• Copyrights, brands, software, patents, trademarks, etc.

6
ISEN 302 - 502
504 Fall 2018

Depreciable property
• The Internal Revenue Service requires that the
followings to be met:
1. The property must be used in business or held for the
production of income.
2. The property must have a life that can be determined,
and that life must be longer than a year.
3. The property must be something that wears out, decays,
gets used up, becomes obsolete, or loses value from
natural causes.

Example:
Land: non-depreciable (does not wear out)
Building: depreciable

7
ISEN 302 - 502
504 Fall 2018

Depreciable property: example

• Joe runs a pizza place. He classifies some of his costs as
follows (further into expense or depreciation).
• Depreciation requirements: (1) used in business; (2) a life
longer than a year; (3) something that wears out.
Item Type of costs Reason
Pizza dough,
toppings Expense Life < 1 yr; loses value immediately
Delivery van
Employee Depreciation Satisfies all requirements
wages
Expense Life < 1 yr; loses value immediately
Furnishings
Baking oven Depreciation Satisfies all requirements
Utilities Depreciation Satisfies all requirements
Expense Life < 1 yr; loses value immediately

8
ISEN 302 - 502
504 Fall 2018

Depreciation terminologies
Cost basis (): the amount paid for acquisition
and installation of a depreciable asset.
Depreciation allowance/charge
(): the periodic amounts that may
𝑃 be deducted from taxable
income.
𝑑𝑡
Book value ():
𝐹 𝐵𝑡 the
undepreciated
portion of an
asset.
0 -1 𝑡 time

Salvage value (): the estimated market

value at the end of the asset’s useful life.

9
ISEN 302 - 502
504 Fall 2018

Various methods of calculating depreciation

• There are several methods of calculating depreciation
(SLN, DB, MACRS).
• They differ in how the depreciation charges change
over time.

10
ISEN 302 - 502
504 Fall 2018

Straight-line depreciation (SLN)

• The depreciation method that treats annual depreciation
charges as a uniform annual series.
• Linear decrease implies , so uniform series of expenses.

𝐵𝑡 • : useful life of an asset

𝑃 𝑑1 • : year; 1, 2, ,
𝑑2 • : cost basis
• : salvage value at the end of
𝐵1 𝐵2 the useful life
𝐹 • : depreciation charge for year
• : book value at the end of
year
0 1 2 ⋯ 𝑛
11
ISEN 302 - 502
504 Fall 2018

Straight-line depreciation (SLN)

𝐵𝑡 𝑑 1=𝑑 2=⋯=𝑑 • Depreciation charge for
𝑃 𝑑1 year
𝑑2

𝐵1 𝐵2
𝐹
• Book value after years
0 1 2 ⋯ 𝑛 of depreciation

• Excel function to calculate the annual depreciation

charge
SLN()

12
ISEN 302 - 502
504 Fall 2018

Straight-line depreciation (SLN): example 8.1

An SMP machine costs $500,000 and has a $50,000
salvage value after 10 years of use. Using straight-
line depreciation, what are the depreciation charge
and book value for the machine after year 5?
Given:
cost basis = $500,000;
salvage value = $50,000;
useful life = 10 years.

Find: ,

13
ISEN 302 - 502
504 Fall 2018

Straight-line depreciation (SLN): example 8.1

• Depreciation charge
= = ()/ = ()/10 = $45K

• Book value
= = ) = $275K

14
ISEN 302 - 502
504 Fall 2018

Declining balance (DB) depreciation

• DB is a type of accelerated depreciation: larger
depreciation charges in the early years and smaller
depreciation charges in the later years.

• The depreciation charge in a given year is a fixed

percentage () of the book value at the beginning of
the year.

𝒅 𝒕 =𝒑 𝑩 𝒕 −𝟏

15
ISEN 302 - 502
504 Fall 2018

Declining balance (DB) depreciation

• Example: and
End of year Depreciation Book value

1 0.2 * $1000 = $200 $800

2 0.2 * $800 = $160 $640

3 0.2 * $640 = $128 $512

4 0.2 * $512 = $102.4 $409.6

5 0.2 * $409.6 = $81.9 $327.9

6 0.2 * $327.9 = $65.5 $262.4

7 0.2 * $262.4 = $52.5 $209.9

• Observe that the depreciation charges decrease over

time.
16
ISEN 302 - 502
504 Fall 2018

Declining balance (DB) depreciation

𝐵𝑡 𝒅 𝒕 =𝒑 𝑩𝒕 −𝟏 • =
• = = =
𝑃
𝑑 1=𝑝𝑃
𝑑 2=𝑝 𝐵1 • = =
• = =
=
𝐵1
𝐵2
• =
0 1 2 ⋯ 𝑛 • =

• Notice that the salvage value is not incorporated in the

calculations for DB (unlikely to have ).

17
ISEN 302 - 502
504 Fall 2018

Declining balance (DB) depreciation: choice of

• Common practice
• Use 125%, 150%, 200% (IRS max) of the SLN rate.
• SLN rate:
• Maximum rate (200% of the SLN rate):
• Double declining balance (DDB) depreciation: DB plan with
(the maximum rate)

• If it is desired to use a percentage making ,

• Solve the above equation for  = 1 – ()1/

• Note that the depreciation rate should not exceed .

18
ISEN 302 - 502
504 Fall 2018

Declining balance (DB) depreciation: example 8.2

An SMP machine costs $500,000 and has a $50,000 salvage value
after 10 years of use. Using declining balance depreciation, what
are the depreciation charge and book value for the machine
after year 5?

• Depreciation rate • Suppose that we use DDB

= 1 – ()1/ (i.e., = 0.2)
= 20.5672% =
> 20% = 2/ =
(max level)
=
=
=
19
ISEN 302 - 502
504 Fall 2018

Switching from DB to SLN

• Depreciation charges given by DB is larger than SLN in
early years, but becomes smaller later.
• To maximize the of depreciation charges, we switch
from DB to SLN.

• The optimum time to switch is

𝑃 the smallest such that , i.e.,

𝐹
0 1 2 ⋯ 𝑛
20
ISEN 302 - 502
504 Fall 2018

Switching from DB to SLN: example 8.3

An SMP machine costs $500,000 and has a $50,000
salvage value after 10 years of use. What is the optimal
point for the depreciation method to switch from DDB
to SLN?

Given: = $500,000; = $50,000; = 10; = 0.2 for DDB.

Find: The smallest for which , i.e.,

21
ISEN 302 - 502
504 Fall 2018

Switching from DB to SLN: example 8.3

𝐷𝐷𝐵 𝑆𝐿𝑁 𝐵𝑡 − 1 − 𝐹
𝑑 𝑡 =𝑝 𝐵𝑡 −1 𝑑 𝑡 =
𝑛 −(𝑡 − 1)

22
ISEN 302 - 502
504 Fall 2018

MACRS
• Main Difference:
• Follows a certain
Property Class
• Depreciates the
total amount to
0

23
ISEN 302 - 502
504 Fall 2018

Key terms & reading assignment

Key terms
• Depreciation and Amortization
• Tangible (Personal and Real) vs Intangible property
• Straight-Line Depreciation Method
• Cost Basis
• Salvage Value
• Depreciation Charge
• Book Value

Reading assignment: Chapter 8–8.3.1

24
ISEN 302 - 502
504 Fall 2018

Key terms & reading assignment

Key terms
• Declining balance (DB)
• Double declining balance (DDB)
• Modified Accelerated Cost Recovery System
(read section 8.4 in the textbook)

Reading assignment: Chapter 8: 8.3.2 – 8.4

25